Adding grantor tax reimbursement power caused beneficiary gifts

Plain-English summary

An irrevocable grantor trust did not originally permit the trustee to reimburse the grantor for income tax attributable to the trust's income. The trustee later obtained a court-approved modification, with the beneficiaries' consent, giving the trustee discretion to make those reimbursements. Chief Counsel concluded that the modification transferred part of the beneficiaries' interests to the grantor and therefore created taxable gifts by the beneficiaries. The result differs from Revenue Ruling 2004-64, where reimbursement authority was part of the trust's original governing instrument. The same result would apply when state law gives beneficiaries notice and a right to object but a beneficiary does not object. The gifts must be valued under the general gift-tax valuation rules, even if the calculations are difficult.

Ruling snapshot

• Question: Do trust beneficiaries make taxable gifts by consenting to add a discretionary power to reimburse the grantor for tax on trust income?
• Outcome: advice given
• Key authorities: IRC §§ 2501, 2511, and 2512; Treas. Reg. §§ 25.2511-1 and 25.2511-2; Rev. Ruls. 67-370 and 2004-64

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
memorandum
Number: 202352018
Release Date: 12/29/2023
CC:PSI:B04
POSTN-121906-23

UILC:    2511.04-00

date:    November 28, 2023

to:      Janice B. Geier
         Associate Area Counsel, Portland
         (Small Business/Self-Employed))

         Sheila R. Pattison
         Associate Area Counsel, Austin
         (Small Business/Self-Employed)

from:    Holly Porter
         Associate Chief Counsel
         (Passthroughs & Special Industries)

subject: Gift tax consequences of modifying a grantor trust to add a tax reimbursement clause

Issue

What are the gift tax consequences to the beneficiaries when the trustee of an
irrevocable trust, with respect to which the grantor is treated as the owner under
subpart E, part I, subchapter J, chapter 1 (subpart E) of the Internal Revenue Code
(Code), modifies the trust, with the beneficiaries’ consent, to add a tax reimbursement
clause that provides the trustee the discretionary power to make distributions of income
or principal from the trust in an amount sufficient to reimburse the grantor for the income
tax attributable to the inclusion of the trust’s income in the grantor’s taxable income?

Conclusion

The modification to add the tax reimbursement clause will constitute a taxable gift by the
trust beneficiaries because the addition of a discretionary power to distribute income
and principal to the grantor is a relinquishment of a portion of the beneficiaries’ interest
in the trust.

Facts

In Year 1, A establishes and funds Trust, an irrevocable inter vivos trust, for the benefit
of A’s Child and Child’s descendants. Trustee is the current trustee of Trust and
satisfies the governing instrument requirement that a trustee of Trust must be a person
not related or subordinate to A within the meaning of § 672(c) of the Code. Under the
governing instrument of Trust, a trustee of Trust may distribute income and principal to
or for the benefit of Child in the trustee’s absolute discretion. Upon Child’s death,
Trust’s remainder is to be distributed to Child’s issue, per stirpes.

Under the governing instrument of Trust, A retains a power that causes A to be the
deemed owner of Trust under § 671 of the Code, and, accordingly, all items of income,
deductions, and credits attributable to Trust are included in A’s taxable income.

Neither State law nor the governing instrument of Trust requires or provides authority to
a trustee of Trust to distribute to A amounts sufficient to satisfy A’s income tax liability
attributable to the inclusion of Trust’s income in A’s taxable income.

In Year 2, when Child has no living grandchildren or more remote descendants, Trustee
petitions State Court to modify the terms of Trust. Pursuant to State Statute, Child and
Child’s issue consent to the modification. Later that year, State Court grants the petition
and issues an Order modifying Trust to provide a trustee of Trust the discretionary
power to reimburse A for any income taxes A pays as a result of the inclusion of Trust’s
income in A’s taxable income.

Law

Under § 671 of the Code, if the grantor of a trust is treated as the owner of any portion
of the trust under subpart E, those items of income, deductions, and credits against tax
of the trust that are attributable to that portion of the trust must be included in computing
taxable income or credits of the grantor.

Section 2501(a)(1) imposes a tax for each calendar year on the transfer of property by
gift during the calendar year by any individual. Section 2511(a) provides that the gift tax
applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect,
and whether the property is real or personal, tangible or intangible.

Section 25.2511-1(c)(1) of the Gift Tax Regulations provides that the gift tax applies to
gifts indirectly made. Further, any transaction in which an interest in property is
gratuitously passed or conferred upon another, regardless of the means or device
employed, constitutes a gift subject to tax.

Section 25.2511-1(e) provides that if a donor transfers by gift less than their entire
interest in property, the gift tax is applicable to the interest transferred. Further, if the
donor’s retained interest is not susceptible of measurement on the basis of generally
accepted valuation principles, the gift tax is applicable to the entire value of the property
subject to the gift.

Section 25.2511-1(g)(1) provides in relevant part that donative intent on the part of the
transferor is not an essential element in the application of the gift tax to the
transfer. The application of the tax is based on the objective facts of the transfer and
the circumstances under which it is made, rather than on the subjective motives of the
donor.

Section 25.2511-2(a) provides that the gift tax is not imposed upon the receipt of the
property by the donee, nor is it necessarily determined by the measure of enrichment
resulting to the donee from the transfer. Rather, it is a tax upon the donor’s act of
making the transfer. The measure of the gift is the value of the interest passing from
the donor with respect to which they have relinquished their rights without full and
adequate consideration in money or money’s worth.

Section 25.2511-2(b) provides that as to any property, or part thereof or interest therein,
of which the donor has so parted with dominion and control as to leave in him no power
to change its disposition, whether for their own benefit or for the benefit of another, the
gift is complete. If a donor transfers property to another in trust to pay the income to the
donor or accumulate it in the discretion of the trustee, and the donor retains a
testamentary power to appoint the remainder among the donor’s descendants, no
portion of the transfer is a completed gift. On the other hand, if the donor had not
retained the testamentary power of appointment, but instead provided that the
remainder should go to X or X’s heirs, the entire transfer would be a completed gift.

Rev. Rul. 67-370, 1967-1 C.B. 324, concludes that a defeasible remainder interest in
trust which is subject to termination at the will of another is an interest in property within
the meaning of § 2033 of the Code. The ruling notes that the fair market value of the
interest would be affected by its possible divestment under general transfer tax rules for
the valuation of property, but the value of that interest would not necessarily be nominal.

In Rev. Rul. 2004-64, 2004-2 C.B. 7, a grantor created an irrevocable inter vivos trust
for the benefit of the grantor’s descendants and retained sufficient powers with respect
to the trust so that the grantor is treated as the owner of the trust under subpart E of the
Code. In relevant part, the ruling considers two situations in which the trustee
reimburses the grantor for taxes paid by the grantor that are attributable to the inclusion
of all or part of the trust's income in the grantor's income. In Situation 2 of Rev.
Rul. 2004-64, the distribution reimbursing the grantor is mandated under the terms of
the governing instrument. In Situation 3 of Rev. Rul. 2004-64, the governing instrument
provides the trustee with the discretionary authority to make a reimbursing distribution.
In both of these situations, when the trustee of the trust reimburses the grantor for the
income tax paid by the grantor, the ruling concludes that the payment does not
constitute a gift by the trust beneficiaries because the distribution was either mandated
by the terms of the governing instrument or made pursuant to the exercise of the
trustee’s discretionary authority granted under the terms of the governing instrument.

Analysis

Under the governing instrument of Trust, Child and Child’s issue each have an interest
in the trust property. As a result of the Year 2 modification of Trust, A acquires a
beneficial interest in the trust property in that A becomes entitled to discretionary
distributions of income or principal from Trust in an amount sufficient to reimburse A for
any taxes A pays as a result of inclusion of Trust’s income in A’s gross taxable income.
In substance, the modification constitutes a transfer by Child and Child’s issue for the
benefit of A. This is distinguishable from the situations in Rev. Rul. 2004-64 where the
original governing instrument provided for a mandatory or discretionary right to
reimbursement for the grantor’s payment of the income tax. Thus, as a result of the
Year 2 modification, Child and Child’s issue each have made a gift of a portion of their
respective interest in income and/or principal. 1 See § 25.2511-1(e) and § 25.2511-2(b).
See also Robinette v. Helvering, 318 U.S. 184 (1943). The result would be the same if
the modification was pursuant to a state statute that provides beneficiaries with a right
to notice and a right to object to the modification and a beneficiary fails to exercise their
right to object.

The gift from Child and Child’s issue of a portion of their interests in trust should be
valued in accordance with the general rule for valuing interests in property for gift tax
purposes in accordance with the regulations under § 2512 and any other relevant
valuation principles under subtitle B of the Code. 2

Section 6110(k)(3) provides that this document may not be used or cited as precedent.

Please call Daniel J. Gespass at (202) 317-6859 if you have any further questions.

                                                  Sincerely,

                                                  Associate Chief Counsel
                                                  (Passthroughs & Special Industries)

                                                  _________________________
                                         By:      Karlene M. Lesho
                                                  Chief, Branch 4

1
  PLR 201647001 concludes that the modification of a trust to add a discretionary trustee power to
reimburse the grantor for the income tax paid attributable to the trust income is administrative in nature
and does not result in a change of beneficial interests in the trust. These conclusions no longer reflect
the position of this office.
2
  Although the determination of the values of the gifts requires complex calculations, Child and Child’s
issue cannot escape gift tax on the basis that the value of the gift is difficult to calculate. See Smith v.
Shaughnessy, 318 U.S. 176, 180 (1943) (“The language of the gift tax statute, ’property . . . real or
personal, tangible or intangible,’ is broad enough to include property, however conceptual or contingent.”)

Office of the Associate Chief Counsel
(Passthroughs and Special Industries)